According to Propublica, a hedge fund called Magnetar put together a trade back in 2005 to take advantage of a collapsing mortgage market. It worked like this:

  1. notice that CDOs are broken into tranches, with lots of demand for the lower risk tranches, and significantly less demand for the riskier (equity-like) tranches
  2. buy equity tranches of mortgage-backed CDOs, using buyer clout to harangue the deal operator into putting riskier mortgages into the pool
  3. use buyer clout to remove triggers from the CDOs which stop payment to riskier tranches when the market deteriorates
  4. use the recurring income from your equity tranche to offset purchases of credit default swaps on the temporarily less riskier tranches of the same CDO

Net, say Magnetar pays 100 M$ for the equity tranche, they receive 15-20 M$ annually in mortgage interest. They then buy 15-20 M$ of default insurance on the other tranches. As they scale up, Magnetar makes a huge bet that they will have enough money to carry them over the time period when income from the equity tranche has died and when the valuations rise on the CDSs they purchased.

Finance has an F in it for a reason....